In an interview Kaushik Basu gave to The Hindu on January 24, the former chief economic adviser to the government of India pointed out that when all the recent massaging of India’s growth statistics is filtered out, India’s growth rate has now fallen below the average of the past 30 years. Quite obviously far from bringing back ‘achhe din’, Prime Minister Narendra Modi has taken the Indian economy back to something that is beginning to look dangerously like the “Hindu rate of growth” in a new saffron avatar.

What is responsible for this? The short, blunt answer is the exorbitantly high interest rate regime imposed by the Reserve Bank of India almost eight years ago to curb a short spasm of inflation, which was then maintained relentlessly by a succession of its governors in the face of a pusillanimous finance minister irrespective of how much inflation has fallen.

This has killed Indian industry.

Today, the sum total of non-performing loans has reached the terrifying figure of Rs 9,50,000 crore, or $140 billion. Worse still, Rs 1,140,000 crore of capital has been wasted on what the government euphemistically calls ’stalled’, but which are in reality abandoned projects. And worst of all, no fewer than 500 companies that had invested this money are now facing bankruptcy proceedings, and will have their remaining assets sold off at a fraction of their value in the next few years.

Why is the RBI doing this? What model of banking is it aspiring to emulate? To understand this, it is necessary to understand the history of the RBI. A recent, racily written, book by well-known economic journalist TCA Srinivasaraghavan gives insights that help understand its motivation. TCA points out that banking grew out of the need of the rulers to finance war. This gave bankers an early ascendancy over the State that they misused for two centuries before the Wall Street crash of 1929. That, and the Great Recession that followed, forced the United States and European governments to create a lender of the last resort, i.e a central bank that would not only backstop, but also control, all other banks but itself be controlled by the government.

Therein lay the rub. For governments were no less capable of abusing their power to create money than the banks that they set out to tame. This sowed the seeds of a conflict between central banks and governments that ended in Britain, with the Bank of England wresting full control of money supply from the treasury after the ‘Black Monday’ financial crash in 1992, but has still not ended in India.

The road to autonomy

In India, this struggle began almost on the very day the RBI was born. Till World War I, the financial system of British India had been managed independently by the three presidencies of Bombay, Bengal and Madras. But when the Crown ousted the East India Company after the 1857 uprising, one of the demands it faced was for the creation of a single central bank for India modelled on the Bank of England.

Before then, this need had been partly met by merging the three presidency banks into the Imperial Bank of India, which acted both as a commercial bank and a lender of last resort. This arrangement lasted till the Reserve Bank of India was created in 1935.

Although London made the RBI a shareholders’ bank in an unmistakable signal that it clearly wanted the RBI to be independent, and deliberately did not buy shares in it, New Delhi had other ideas. Governors who refused to toe the line were first warned and then sacked if they did not get the message. The relationship was characterised by Montagu Norman, the longest serving head of the Bank of England, as a ‘Hindoo marriage‘ wherein the wife advises but does what she is told.

The struggle ended in 1949, when the new Indian government nationalised the RBI. Till the economic crisis of 1990-91, New Delhi exercised the power to create money through the issue of treasury bonds. This kept the control and regulation of money supply firmly in the hands of the Ministry of Finance. The RBI’s role was the subordinate one of managing the money already created and administering the interest rates , cash reserve ratios and statutory liquidity ratios fixed by the government. Its advice was, of course , sought, but not necessarily heeded.

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The seeds of its future autonomy were sown by three separate developments: the break down of the Bretton Woods system of fixed exchange rates in 1971-73; the oil price shocks of 1973 and 1978, and New Delhi’s consequent need to go to the International Monetary Fund (IMF) for emergency funding, and the external debt crisis of 1990-91.

The first required a constant monitoring of foreign exchange inflows and outflows and the creation of a managed float exchange rate system. The second was made conditional upon a substantial loosening of industrial licensing and import controls. The two together made exchange rate management a key function that automatically devolved upon the RBI. The result was a managed float of the exchange rate which has administered, day by day, by the RBI.

The freedom to print money remained, however, with the finance ministry till the external debt crisis of 1990-91 finally prised open the Indian economy. The switch to a market economy , the opening up of the financial sector to private banking, current account convertibility and the inflow of foreign direct investment (FDI) and foreign institutional investor (FII) made it imperative to coordinate exchange rates, interest rates and money supply and to regulate the commercial banking sector through monetary signals.

Only the RBI was capable of doing all this. The Narasimha Rao government enshrined this acceptance in an all-important agreement between finance minister Manmohan Singh and RBI governor C. Rangarajan to end the issue of treasury bills by the ministry of finance by 1997 and manage the supply of credit entirely through the RBI in future.

With this, the RBI finally obtained a degree of autonomy comparable, although by no means equal, to that of central banks in the high income market economies.

Ailments and clashes

But this autonomy brought a new problem to the fore. This is the clash between economic growth and price stability. The RBI is required to maintain price and exchange rate stability. The government was required to promote growth and create employment. But it is an axiom of development economics that rapid growth creates inflationary pressures. Thus, reconciling the two aims requires the closest cooperation between the two.

TCA correctly points out that this balance was best achieved between Bimal Jalan as the governor of the RBI and Yashwant Sinha (followed by Jaswant Singh) as the finance minister. Their cooperation resulted in a steady reduction of both government administered deposit rates like interest of provident fund and postal savings, and the lending rates of the commercial banks. This re-ignited growth after the five-year recession of 1997 till 2002.

Y.V. Reddy. Credit: PTI

Formally, TCA ends his analysis of the RBI’s evolution in 2008 at the end of Y.V. Reddy’s stewardship of the RBI, because that is where his research materials ended.

Although he skated over the Subba Rao period in just a few pages, he has had nothing to say about Raghuram Rajan’s three years. This is a pity because it is in these three years that the autonomy of the RBI became absolute and it succeeded in stopping industrial and employment growth in the country.

The doctrine that both used to do this – Subba Rao implicitly, but Rajan explicitly – is “inflation targeting”, whose central tenet is that high inflation hurts economic growth, and lowering it automatically restores growth. Both therefore made the control of inflation the one-point agenda of the RBI. This doctrine was cock-eyed to start with, but by 2013 so complete was the RBI’s dominance over the ministry of finance, that no finance minister in Delhi (Arun Jaitley) has dared to take the RBI governor to task or challenge the theoretical basis of his addiction to high interest rates.

The truth is that inflation targeting is not an economic tool to foster growth but a political tool devised by the richest industrialised countries to enable them to continue living far beyond their shrinking means, by drawing, free of cost, upon the savings of less fortunate countries.

Inflation targeting attained the status of a doctrine – a one-stop cure for all developmental ailments – only when it was adopted by the industrialised countries in the 1990s. Its rationale developed out of Britain’s exchange rate crisis in 1992. Britain had been living way beyond its means, with an average inflation rate of 11% and a balance of payments deficit of 8% of the GDP for 20 years from the early seventies. Initially, this caused the pound to depreciate rapidly against the dollar. Then North Sea oil hit the market and the pound recovered till it was once more worth well over two dollars at the end of 1978.

When oil prices crashed in 1986, this underpinning of the pound disappeared. But for six years, the Margaret Thatcher government resisted pressure to devalue the pound, by informally linking it to the Deutsche Mark, and later joining the European Exchange Rate Mechanism (ERM) , and raising interest rates to keep attracting foreign savings. This house of cards collapsed on ‘Black Wednesday‘ in 1992, when it was forced to leave the ERM and massively devalue the pound. At that point, inflation had been running at 11% for 20 years, and the balance of payments deficit was 8% of the gross domestic product (GDP).

Devaluation stemmed the outflow, and eventually helped revive British industry. But in its immediate aftermath, it left Britain to face the task of reviving confidence in the future stability of the pound. Inflation targeting was the policy forged by the Bank of England to do this. It was, in effect a declaration to the rest of the world that it could park its money safely in pounds sterling, because the British government would never allow inflation to threaten its stability again.

Not surprisingly, inflation targeting has become the bible of of the industrialised countries, all of whom are facing de-industrialisation, shrinking tax bases and rising welfare bills because of their aeging population. And it has worked, for Britain has continued to run a balance of payments deficit of 7% of GDP, and has run up a national debt amounting to 90 percent of its GDP. The US has similarly been financing a half-trillion dollar annual balance of payments deficit from foreign savings and now has a national debt verging on 20 trillion dollars – well over twice its GDP.

In India, only Bimal Jalan, as TCA points out, had no time for inflation targeting. Nor, he said would he commit India to maintaining a specific exchange rate. Instead, he told the Foreign Exchange dealers’ association, “… the declared policy of the RBI is to meet temporary demand-supply imbalances which arise from time to time… our our objective is to keep market movements orderly and ensure that there is no liquidity problem or rumour or panic-induced volatility”.

The RBI’s task therefore, he asserted, was to manage price and exchange rate fluctuations within the framework of policies determined by the elected government of the country, and not to supplant that government in the setting of objectives or making of policy.

Regrettably, Modi chose to use neither Jalan nor Yashwant Sinha, and put all his eggs into the basket of a lawyer.